Guest Post: Moving into Bonds - From Frying Pan to Fire

The other day, I came across an article that said, while
individuals may be moving their money out of equities, they have been
moving into bond funds – and in a big way.

It’s called jumping from the frying fan into the fire.

Based on my experience as a co-founder of a mutual fund group, I
can tell you that if there is one sure thing in this world, it’s that
when investors rush en masse into an investment category, it is
invariably at almost exactly the wrong time to do so. Is that the case
with today’s rush into bonds?

To shed some light on that point, Casey Research Switzerland-based
editor Kevin Brekke volunteered to look into the correlation between
bond flows and performance. Here’s his report…

Thinking About Bonds

By Kevin Brekke

With the great bond stampede that began in 2009 continuing, giving
rise to the very real possibility of a bond bubble, we decided to check
the relationship between bond returns and bond fund inflows to see if
there might be a correlation. Take a look at this chart:

(2) Plotted as the three-month moving average of net new cash flow
as a percentage of previous month-end assets. The data exclude flows to
high-yield bond funds.

As suspected, the rise and fall in total return from bond funds is
accompanied by an influx or exodus of bond investors. Data to construct
the chart were taken from the Investment Company Institute’s (ICI) 2010 Fact Book where they state,

In 2009, investors added a record $376
billion to their bond fund holdings, up substantially from the $28
billion pace of net investment in the previous year. Traditionally,
cash flow into bond funds is highly correlated with the performance of
bonds. The U.S. interest rate environment typically has played a
prominent role in the demand for bond funds. Movements in short- and
long-term interest rates can significantly impact the returns offered
by these types of funds and, in turn, influence retail and
institutional investor demand for bond funds.”

ICI continues by noting that secular and demographic trends have
tempered the appetite for equities. An aging population tends to become
risk averse, and the Baby Boomers are entering retirement and seeking a
safer alternative to the stock market. This occurrence is clearly
shown on the right side of the chart. Following the stock market crash
in 2008, investors exited stocks and bonds as general panic
prevailed. As investor calm returned, a tidal wave of new money flowed
into bond funds, turning 2009 into a record year.

And the popularity of bond funds continues. So far this year,
investors have funneled $200 billion in new money into bond funds. 2009
was also a record year for total assets and net new capital in bond
funds from retirement accounts.

That is the view through the macro lens. Switching to a wide-angle lens gives one pause.

We can’t help but draw similarities to the housing bubble that
began inflating at the start of the new century. As home prices started
escalating, they drew the attention of a growing pool of investors. And
soon this becomes a self-reinforcing phenomenon; higher prices attract
greater numbers of investors that drive prices higher. Likewise for
bonds. Bond returns are rising because bond returns are rising. Got it?

We have entered the terminal phase of a bond bull market ushered in
thirty years ago by Paul Volcker, who drove interest rates over 20%.
With 30-year U.S. government paper now under 4%, the easy profits have
been made and the low-hanging fruit consumed. Investors today are
shimmying out on a very tall and thin branch in search of higher “total
return.” The snapping of the branch – sending investors big losses –
may not be imminent, but it is inevitable.

As we at Casey Research have discussed and warned about often, the
fiscal misadventures of the U.S. government will have their
consequences. And one of the first victims will be bond investors as
interest rates are forced higher, much higher, to attract buyers,
particularly foreign buyers. When this happens, the total return on
bond funds will be smashed.

The sad and pathetic irony: to escape the beatings endured in the
stock markets, millions have sought safety in bonds. The punishment is
not over.

We are afraid an awful lot of investors will be left asking, “What was I thinking?”

People have a hard time with the concept of capital destruction, even though it's a required part of our system, and it's happening every second. They have an especially hard time when it's their capital.

This is really a difficult scenario for insurance companies. They have the vast majority of their investments in fixed income. Thanks to this Fed-engineered bond bubble, prices are great. Too bad insurance companies don't have the option of selling high. They have to keep plowing proceeds from maturing securities into bonds with ever-lower yields. I'd be popping antacids like candy if I was an insurance company's portfolio manager right now. What choice do they have but to buy the junkiest investment-grade securities available AND STILL fall short of their target yield.

Some equities are countercylical. For instance, the Canadian market tends to outperform during a rising interest rate environment, against the US market. This is because, disproportionately represented amongst Canadian stocks are those in oil and gas, mining/gold, and banks that have positioned themselves to have little or no interest rate risk.

The 'stock market' is not a monolithic thing. Certain countries are positioned better than others.

No, the reason for such is that the inflation that is co-occurs with depreciating currency and depreciating long-term bond prices, tends to be very beneficial to resource-based economies such as Canada.

I think a bond collapse is further out, if at all. Yields cannot rise at this point, there is no demand at 5%, what demand will there be to borrow at 15%?

Roll your 401 into self-directed. Then you can buy whatever you want.

There is no 401 safe harbor from bond crash, because none have a true cash option and the MMAs can buck-break. I'm in GSE sponsored debt and miners...there are some trades to be had on foreign funds, but the volatility out there on carry trade targets is often severe.

I recently met someone who cashed his 401k. He was informed by some apocalyptic christian publication - go figure. Anyway his 60k turned into 43k after taxes. His co-workers who thought he was crazy and didn't cash out like he reccomended have 12k remaining.

Presumably you refer to a dollar BILL. The dollar as commonly referred to is a bill, not a bond, and it is a special type of bill that pays no interest. MZM. And unlike a bond, which is a form of a derivative as compared to currency ("money"), the dollar bill is the "real" deal.

But all this is O/T re the post above. So what he has shown is that money chases returns. And sometimes it is a leading indicator. What you can't tell from this chart though is the to-date secular bull market in interest rates and whether it has finally ended. Should investors/traders buy the next bump-up in rates? Was the NAZ overpriced Jan 1, 1999? Did it more than double in the next 14 months?

So, AUD, perhaps the bond bull either has died of old age and Timmy's (et al) excesses, or it hasn't died yet; but the realization that a dollar bill is technically a "bill" or a "note" (Federal Reserve obligation) I doubt will be required for the bull to turn into a bear. Perhaps it will simply end when JPM and GS are short enough bonds.

With unlimited credit (money) supply made available by US Federal Reserve (and other central banks for that matter) I am puzzled to see how the price of money (interest) can go very high. It surely fluctuates but for it to jump by any measurable amount there must be a shortage of capital. And who cares about foreign buyers, the FED can step in and buy USTs instead to keep them bid up. Incidentally China has been reducing their net UST holdings and as we all see bond yields are near record lows. So it seems to me that the foreigners dumping USTs and causing a collapse is as much a myth as the decoupling theory.

That's the sort of logic that occurs at the end of bubbles - that "this time will be different". Yes, the Fed can buy UST's. Yes, it could even buy all of them being issued. Could even buy all of them outstanding. The Fed can print unlimited money.

But can it? Confidence in a fiat currency is lost slowly at first, quickly in the middle, and shockingly quickly in the end. In Weimer Germany, hyper-inflation blossomed in 2-4 months. It slowly built over time, and then exploded.

If the Fed was buying all of our UST's and everyone knew that NO ONE else wanted them - what would happen to their prices? Interest rates? Can the US afford to finance the debt at 10% interest rates? What happens when the average citizen wakes up to the fact that the Fed is privately held (I'm not holding my breath on this one)? [How about what happens people wake up to the fact that the US Treasury <could> issue their own money without having to pay interest? I'm no MMT'er, but that would be the only way to actually legally issue currency - especially if it was backed by PM's.]

Back in the financial panic of 2008, I was buying corporate bonds for 50 cents on the dollar. Levi's, RCL, Smithfield, Dole, etc. There were no buyers.

Can't happen again? Can't happen to UST's? You just wait. Grab some popcorn. It's going to be a doozy.

What happens when the average citizen wakes up to the fact that the Fed is privately held (I'm not holding my breath on this one)?

And, why would the Fed, being privately owned by US and European banks buy every UST when it becomes clear to them that it isn't in their interest to bankrupt themselves to save the US? The Treasury may have to go down with the ship but the Bank owned Fed would likely save themselves at some point before self destructing.

Uhhh, you do know that the Fed can print money, right? It can't go bankrupt. It can bankrupt the economy, but the Fed itself always has access to as many dollars as it wants.

Also, they already have gold, so I doubt they would complain about it going up in value once they see the writing on the wall (or they no longer have their gold, and they are just trapped and/or don't know what they are doing, as they are run by economic witch doctors).

I realize that they can print out of thin air but, why wouldn't they, at some point se that that would lead to hyperinflation ....wouldn't the self preservation instincts of the Rothschild's, UBS elements of the Fed trump the urge to "save" the US?

Why do these articles always claim that bond traders are looking for "safe yield"?? It's simply a macro play on the deflationary collapse of Western Civ--and so far, it's been paying off in spades, for all this "dumb money". Safe yield, my ass...

Yeah no kidding, the modern version of 'deflation' assumes that governments can remain extremely irresponsible, and that the welfare state is sustainable, worn out and largely depleted industry (worldwide) be damned.

Really, 'deflation' is just a ludicrous plot by the bankers to get you to invest all your money in bonds, and pay back debt. They know what's coming, that's why they're on the opposite end of the trade.

That's so true Pitz, people think it's normal to be levered 9:1 with an illiquid and non-divisible asset such as a house, but they think you're crazy to be levered in a highly diversified portfolio (mine is diversified along US, eafe, emerging markets, real estate, etc, etfs). So even if I levered close to a margin call (which I don't, I keep leverage with a wiggle room before it ever got close to margin calls) and got a margin call, at most I would have to liquidate part of my portfolio, while if a house gets underwater or you can't make payments (equivalent to a margin call), you have to liquidate the whole house - at least I never heard of just giving up a room or a bathtub to the bank.

The craziest is to actually have most of your wealth invested in one asset class, be it bonds, houses or equities (among those, I'd go with equities, cause they are real claims in assets which may include, real estate and bonds, commodities, products, etc...)

I even talked to people who say margin is risky, but then they use options to "hedge" risk. Options are so much worser than margin, cause you have a pre-defined margin call date, and if the market is against your position at exp date, tough luck, you lose everything you invested!

Anyway, maybe I'm a risk lover, but I still think it's safer to be short a fiat currency with benny money printing and long equities than putting money in us treasury bonds, but I guess I understand the baby boomers who are scared shitless from equities and don't have the option to wait for equities to recover in the long term...

PS: This same people also think us and developed equities were safe and emerging markets risky, but if you look at long term past and future perspectives, disconsidering short term volatility, emerging were the safest and best performing assets in the last 10-20 years (if you're highly diversified among countries and equities of course, I'm comparing indexes, not individual companies or countries)

I just feel sorry for the people who got raped in real estate and equities, sold off during the crisis and now are being fooled again by investing in long term bonds.

Only if you're sure the Fed won't go ahead with QE2. Bonds can go bad either by prices dropping (if there's no QE2) or inflation (if there is QE2). Going long you get killed either way. Going short you collect on the former, but still get killed on the latter.

I call BS. Investors
are returning to the
the pre-equity cult
mix of 50-50 stocks/
bonds because stocks
are at least 30% overpriced on a GAAP
earnings basis and
delivered 0% returns
over the last 10 years. Even so, most
folks still hold too
high a proportion of
stocks today (about
70%) relative to bonds. There's a long way to go on bonds just to get back to a saner pre-1982 mix.

In theory yes, but it's not only a question of how much capital is looking for safer returns. When too much spending is brought forward, and too much nominal wealth is in the form of claims against future production, and nominal wealth exceeds the prospective productivity of the population and its real assets, one way or another that excess nominal wealth will get wiped out. First, equity implodes and safety-seekers pile into bonds, but if that's not enough, and in our case it's certainly not enough, then later the bond holders must get crushed, either through default or inflation.

Fair statement. But I'll jump that
bridge when we come to it. For the
moment, most of the "bond bubble" calls are coming from sell side equity
strategists trying to herd the sheeple
back into stocks for a final shearing.

Let's get one thing straight: if you're absolutely convinced we're heading towards a protracted debt deflation cycle, keep buying them long bonds, they will outperform everything else. If on the other hand, you think stagflation is in the cards, then you will get burned on nominal bonds. Only inflation-sensitive bonds will protect you if stagflation occurs.

That is, if CPI (or whatever inflation index used) is actually reported correctly. And why not just buy equities instead if you believe in the scenario where the inflation-adjusted bonds are going to have value? A 1% real yield on TIPS is like a P/E of 100 on a stock (but you can buy the market for far less than 15X earnings right now!).

I'm generally okay with the rationale of "historical preservation of wealth" theory for gold, though I am strongly inclined to believe it will prove wrong for the simple reason that there is no history of a global civilization that falls from lack of oil.

But beyond that, here's the thing. Mortgages default. In the trillions. That's not an increase in money supply. That's a decrease. When the Fed buys bonds to hold their price up, and does so every single time there appears to be a risk to the bonds, they are not "flooding the world with fiat currency and debasing its value". They are not ADDING. They are REPLACING.

The housing collapse eliminated net worth. It eliminated dollars from existence, and this will go on until starvation from oil scarcity sets in. As that money is erased from the universe, the Fed is printing to replace it.

Replacement is not going to destroy the value of the money so that gold emerges triumphant. Replacement is just going to buy time until oil, and then food, disappears.